Massive Inflation is Assumed by Government

Some more light snow all day here in Massachusetts. It just keeps coming! I cannot complain if reader Watchtower has to endure days without end of ice and no electricity. Keep warm my friend!

Reader Input
Loyal reader Lisa was kind enough to supply an address for her own blog titled Capitalist Preservation. The site looks very sharp and professional. Lisa has daily posts that track breaking news and trade able information. Who knew we had a rogue trader in our midst?

The Mother Load (or Lode?)
All the gold ever mined would just fill up two Olympic sized swimming pools. In man's quest for the yellow metal, he has to look in new places to find more supply. In Japan the search extended to the end result of "daily operations" if you will, and found that sewerage can be your friend in times of need:

Reuters
Japan sewage yields more gold than top mines
TOKYO (Reuters) – Resource-poor Japan just discovered a new source of mineral wealth -- sewage.
A sewage treatment facility in central Japan has recorded a higher gold yield from sludge than can be found at some of the world's best mines.
An official in Nagano prefecture, northwest of Tokyo, said the high percentage of gold found at the Suwa facility was probably due to the large number of precision equipment manufacturers in the vicinity that use the yellow metal.
The facility recently recorded finding 1,890 grams of gold per tonne of ash from incinerated sludge.
That is a far higher gold content than Japan's Hishikari Mine, one of the world's top gold mines, owned by Sumitomo Metal Mining, which contains 20-40 grams of the precious metal per tonne of ore.
The prefecture is so far due to receive 5 million yen (39,075 pounds) for the gold, minus expenses.

As they say, if life gives you lemons, make lemonade. Here, if life gives you sludge deposits, make gold ingots! Sewerage may be the new mother load!

An Excellent Use for TARP 2.0
I am opposed to any new federal spending to support failed banks. I may be convinced otherwise if one little, itty, bitty provision was attached to the TARP 2.0 legislation. Here are my conditions:

-All 100 US Senators are to be audited by the IRS in 2009
-200 House of Representatives members are to be audited by the IRS in 2009

It seems only fitting that as the US Congress is putting the TAXPAYER on the hook for any and all banking losses, we should first find out if in fact the members of Congress are even taxpayers to begin with. There is something vile in the way that our government seems to have no qualms about saddling the population with mountains of bad debt while they themselves do not even pay their share. Maybe that is why they do not care, they are not paying anyway! Perhaps we could set up a "Good Senator, Bad Senator" scheme where the tax dodgers have their IRS bill payed for by the taxpayers as well. Why not indeed.

Massive Inflation is Assumed by Government
There were at least 3 stories out today that chronicle all the problems the new Administration is having with the "Bad Bank" idea. You can read a CNBC piece here. Everything boils down to the simple fact that the Banks refuse to sell the worst of their mortgage backed and other credit assets unless they receive almost full value for them. While the government would LOVE to do just that, they are afraid that the political fallout from such a handout may be large. Additionally, the vast sums needed to fund such handouts are actually scaring high level officials! Now that will keep me awake at night. A number that scares even those in Washington? That has to be in the 5-6 Trillion dollar range if true.

The total disconnect between the banks and reality got me to thinking about how in the world the US government thinks they can get out of this without crushing losses. The only thing I can come up with is that the advisers to the decision makers are pretty sure that a hefty dose of inflation is on the way. Let me explain.

There are perhaps no two economic terms that have more perceived meaning than "Inflation" and "Deflation". You can read about money supply views, Austrian views, and asset price views which will all define these two terms in slightly different ways. For me the easiest way to picture Deflation is thus:

-I will not buy that 200,000 home TODAY because TOMORROW the home will cost 100,000 and I can buy two then with my money that is WORTH MORE.

The opposite view sums up my take on Inflation:

-I must buy that 200,000 home TODAY because TOMORROW the home will cost 400,000 and my money will be WORTH LESS.

Now I do not want to get into deep debate about what exactly deflation/inflation may or not mean by various measures. This is how I think about those two phenomena.

With that in mind, the government seems to think that if they buy bad assets at say 75 cents on the dollar (versus the market price of 25 cents on the dollar) that one of two things must occur to break even:
1.)The market price is wrong
2.)The future price of the assets will at some point make them whole due to massive inflation

Assumption number 1 is out. The market is correct on the pricing, and the pricing is only going to get worse going forward. There will be no magical resurrection of credit instrument values. Not any time in the near to medium future (10-15 years).

So that leaves us with assumption number 2. How would this work? Consider the purchase of Toxic asset A:
-Bank valued at 1 Million dollars
-Market valued at 300,000 dollars
-Government buy price is 800,000 dollars

So right now the government is sitting on a loss of 500,000 for Toxic asset A. That's not very good. But now consider that the government has an inside man at the monetary controls. Someone with access to a printing press and a warmed up helicopter (This could be anyone, so please do not assume I am referring to Ben Bernanke!). US dollars are created and sent out in droves. If all goes well, inflation returns and through the magic of dollars that are worth less, Toxic asset A has a new value in 5-10 years of 900,000 dollars! The government actually made money on the deal! What's not to like?

If successful, the kind of rampant inflation needed to get the toxic asset prices up will be dangerously high. While it works out in a strictly numerical sense, the diminished dollar will have serious consequences.

And it may be wrong to assume it will even work. Credit is being destroyed faster than even the FED can print it up. Credit appetite has also cratered. Wages are in no way, shape or form going to rise anytime soon. It is hard to see how the government is going to create the kind of inflation it needs.

I am sure the boys at the FED and the Treasury have a bunch of fancy charts and graphs that sketch out how this will occur, just like in their textbooks back at school. I am sure they will try. They might even succeed. Sadly there seems to be only two end results here, neither can be thought well of. On the one hand if the government is successful in creating inflation to the degree that covers their stake in toxic assets, you are going to be poorer. A whole bunch poorer. Like really bad off. If they fail, the USA may be looking at a default moment. Again, you are really not going to like that one bit. Not at all. Nope.

The "Bad Bank" plan is due out in the next couple of weeks, as is the TARP 2.0. Also the new stimulus plan is up on deck. The FED today extended their term lending facilities out to October, and will later extend them forever. If this all seems like jamming the system with cash consider the way I have outlined the options available to policy makers. The frenetic money creation has to run hot and heavy. They are already way behind.

Have a good night.